IMF Urges Smarter Taxes to Get Energy Prices Right

Last week IMF managing director Christine Lagarde returned to CGD to make good on a pledge she made two years ago during the run-up to the Rio+20 gathering that marked the 20th anniversary of the Rio Earth Summit.

At that time Lagarde surprised many listeners by framing global challenges in a way that went beyond narrowly defined financial stability to include social and environmental crises that threaten societies and economies, and to suggest that getting energy prices right is an important part of the solution. The IMF, she said, would do its part by offering practical guidance for developed and developing countries.

The big policy implication of the new IMF research: countries need not wait for an international agreement to begin getting energy prices right. They should start taxing the pollution and other negative spillovers of too-cheap fossil fuels now—and begin reaping the benefits.

“Let me be crystal clear: we are generally talking about smarter taxes rather than higher taxes,” Lagarde said. “This means recalibrating tax systems to achieve fiscal objectives more efficiently, most obviously by using the proceeds [from fossil fuel taxes] to lower other burdensome taxes. This revenue could also be used for spending priorities, or to pay down public debt.”

The book and accompanying data—available free on the IMF website—show how to calculate the “corrective tax” for four main fossil fuels—coal, natural gas, diesel and gasoline—taking into account not only climate costs but the health effects of pollution, deaths in traffic accidents, congestion, and even wear-and-tear on the roads.

The authors show the tax that is appropriate for each fuel, and the amount of revenue that could be generated, for some 150 countries. The corrective tax on coal, the IMF calculations show, would be at least 50 percent in today’s prices; for natural gas the optimal tax is smaller, but still 40 percent. The revenue potential is substantial: more than 2 percent of GDP in the United State and more than 7 percent of GDP in China.

Lagarde said that, “Protecting the environment involves a multitude of moving parts,” including: research and development, infrastructure upgrades for power and transportation systems, and appropriate tax and regulatory regimes for extractive industries.

“Yet, in all of this, fiscal policy must take center stage. The message is simple: to get it right, price it right. Make sure that prices reflect not only the costs of supplying energy, but also the environmental side effects.”

How will this new IMF report shape policymakers’ approach to fossil fuel taxes and ultimately the global policy response to climate change?

World Resources Institute president Andrew Steer argued in his comments that “a tipping point could be closer than we think” and that the IMF book and Lagarde’s leadership on the issue may help to hasten its arrival. (See his blog post at WRI for why this may be the case.)

What impact would the IMF recommendations have on poverty, inequality and development—the focus of our work here at CGD?

While heartily endorsing the IMF call for boosting fossil fuel taxes in high-income countries and noting that the IMF research underpins the rallying cry “coal kills,” Birdsall also noted in her remarks (and in this blog post) that higher fossil fuel taxes could be a much burden for poor people than for others.

For example, in Nigeria, she said, the equivalent of a mere US$0.20 increase in daily bus fare expenses would be equal to nearly 20 percent of the median income of $36 a month. Moreover, cuts in direct taxes, such as income taxes, would not compensate poor households for such loses, since poor people in developing countries rarely pay such taxes, she said.

“The solution will be to develop transition paths that combine reducing energy poverty, avoiding greater inequality of overall consumption, and getting closer to ‘right’ prices,” she said, urging that the IMF tackle this challenge in future work. One way to do this is through direct cash transfers, a technique that has become more feasible with recent advances in mobile money and biometric ID, she said.